Quantitative Easing - February 2015

The process involves the ECB creating more money in order to encourage more spending and investment within the Eurozone.

Nick Barnes, Head of Research

Highlights

Background

What is QE and how does it work?

Recent impact of Eurozone QE

Possible future impact of Eurozone QE on the London residential property market

Background

Having hinted on several occasions since August last year that unless Eurozone inflation (currently running at a headline rate of -0.2% against a target rate of +2.0%) picked up the European Central Bank (ECB) would be forced to take further action to stimulate the member states' economies, ECB President Mario Draghi finally announced a major programme of quantitative easing (QE) on 22 January. With the Eurozone equivalent of our Bank Rate already dangerously low at 0.05%, this was seen as the only feasible shorter term alternative. The jury is out on whether the planned €60 bn per month allocated to the programme for at least the next 19 months will achieve its objectives. Either way, the move will have implications for the UK economy, including its residential property market.

What is QE and how does it work?

Simply put, the process involves the ECB creating more money in order to encourage more spending and investment within the Eurozone. This is achieved by buying financial instruments (principally government bonds) from the member states' institutions. The money received by the sellers will either be spent, which will help to boost growth, or it may be used to buy other assets such as shares or corporate bonds. This will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off and they may then go out and spend more. Higher asset prices mean lower yields, which brings down the cost of borrowing for businesses and households, which should provide a further boost to spending. In addition, much of this new money is likely to end up with banks which might lead them to boost their lending to consumers and businesses.

That's the theory, however, there is no guarantee of success. Japan tried it to escape the effects of its "burst bubble" at the start of the 90s and has yet to recover fully, while opinion is divided about how much QE contributed to the UK's economic turnaround in 2013. Even if the banks' coffers swell, there is no guarantee that this extra capital will then filter through to households and corporates as many banks are more cautious about lending following recent regulatory tightening or they may use it to shore up their balance sheets, for example to cover fines for misconduct. Finally, households and corporates may prefer to reduce debt rather than take on additional debt and spend. There is the additional risk that an asset price bubble will be created without gaining traction on the real economy which could have major global ramifications.

Recent impact of Eurozone QE

Regardless of its success or otherwise, what are the likely effects of QE? First and foremost, with more money in circulation the value of the Euro will decrease, which has already happened. On the same day as the announcement of the QE programme, the euro fell to its lowest level against the dollar for more than 11 years and a 7 year low against sterling. Stock markets also reacted swiftly – within a day of the announcement, Europe's stock markets enjoyed their best performance for 3 years.

Europe's bond markets have also responded quickly, including those in troubled southern Europe. Government bond yields have come down, although not as quickly as was the case in the USA and UK, as markets were expecting QE and had to some extent already priced in the effects. Nonetheless, Italian and Spanish 10-year yields both fell to record lows, while Greece's dropped below 9%.

Here in the UK, the FTSE100 posted its best week since December 2011, rising by 4.3%, while sterling reached a 7 year high against the euro. UK bonds were also affected, with long-dated 30-year UK Gilts falling to a record low of 2.12%.

Possible future impact of Eurozone QE on the London residential property market

Looking ahead, whilst an ailing Eurozone (the UK's largest trading partner) is not good news for the UK there are potentially some positive side-effects. The UK, and especially London within a financial services and property context, typically benefits from financial / geo-political upheaval in other countries with which it has links. In a worst case scenario of the Eurozone breaking up and the euro collapsing, Britain would represent the strongest currency in Europe and an obvious safe haven for flight capital. Whilst the likelihood of this happening is remote at present, the result of the recent Greek election has increased speculation about a "Grexit" – i.e. Greece leaving the Eurozone – and triggering a chain reaction among other disenchanted Euroland members.

With regard to property, a long time favourite for investment capital in troubled times, London has received numerous waves of foreign money targeting residential stock - witness the flood of French émigrés descending on London following the introduction of President Hollande's wealth tax in 2012 and the inflows of Greek capital since their economy nosedived. This inflow of capital has helped to sustain prime residential property values and contributed to London's excellent long term performance record which is superior to other major asset classes when measured by total returns.

Assuming the take-up of bonds remains strong, yields will come down further making them less attractive to new investors in comparison to property. At the time of writing, yields on UK 10 year gilts were just below 1.5% compared to gross rental yields (cash purchase) of around 4.3% in London (according to ARLA data). The property yield would of course be enhanced by gearing which is an attractive option while borrowing costs remain low.

If QE, which offers nothing by way of addressing the structural issues which plague Europe, does not achieve its objectives and the Euroland economies stagnate further, stock markets would become more volatile and the euro would almost certainly experience further decline. Given this scenario, alternative assets would receive increased investor interest and property, offering both potential capital gain and rental income, should again be an attractive option. With a large and fast growing privately rented sector and a solid long term track record of capital growth, London would stand out as an obvious target. Given its proven global appeal, the London residential market additionally offers above average liquidity among its peers which would reassure investors with an eye on their exit strategy.

Any upsurge in investor activity would also create upwards pressure on capital values, especially given the imbalance between supply and demand in London. At the end of 2014, only 133 completed stock units were unsold in developments of 20 units and above. At the very least, the prime London residential property market is likely to benefit from the considerable uncertainty surrounding the future not just of the Eurozone but the extent of any collateral damage on international financial markets as the programme of QE unfolds over time.